Gail Bebee is the author of No Hype - The Straight Goods on Investing Your Money. She can be reached at firstname.lastname@example.org; her website is www.gailbebee.com. This is part five of a 12-part series for people that are new to investing on their own.
Stock: A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings . - Investopedia
Those new to direct investing may find the sheer volume of information, charts, financial numbers and pundit commentary on stocks so overwhelming that they elect to let a mutual fund or exchange-traded fund manager make the individual stock purchasing decisions for them.
While picking individual stocks for the equity part of your portfolio does require some time and effort, it can be easier than many investors think. Since you avoid paying fund management fees, the reward is a potentially higher rate of return on your investments.
New to direct investing? The series
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To invest in stocks directly, you need a large enough pot of money that you don't put all your equity investing eggs in one basket. Some studies of past stock market performance have concluded that owning about 15 to 20 stocks provides the best return for the least risk. Assuming you buy 100 shares (the standard trading quantity) of each of 15 stocks at an average cost of $30 per share (no penny stocks, thank you) you'll need about $50,000 for the equity allocation in your portfolio.
If your account balance is more modest, start by buying mutual funds and/or exchange-traded funds and gradually transition into stocks as your portfolio increases. Even if you do have enough cash to buy 15 stocks, it's best to start by buying and following one or two stocks so you can learn the ropes before you fully deploy your cash.
Before making your first stock purchase, it's a good idea to have an overall plan of what you want to buy. Your goal is to assemble a diverse group of stocks to reduce the risk of financial ruin if one stock or one industry sector collapses. Given the correlated crash of stock markets around the world last year, my preferred approach is to diversify by industry sector rather than by geography, and focus on companies listed on North American exchanges. I like to choose stocks from across five general industry sectors that are grouped, broadly speaking, by similar economic behaviour:
- Consumer products and services
- Industrial products and services
- Natural resources
When it comes to picking specific stocks within the above sectors, I think those new to direct investing, and in fact most direct investors, should stick to large, established companies which pay dividends and have a track record of earning a reasonable return for share owners.
Canadians should focus preferentially on stocks of Canadian companies that pay dividends that are eligible for Canada Revenue Agency's dividend tax credit. Many of these companies do significant business internationally, providing additional diversification. Where suitable Canadian stocks are not available (our consumer product, technology and manufacturing sectors are quite thin), foreign companies can fill the gap.
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An easy way to identify stocks you might want to buy is to look at the holdings of several Canadian equity mutual funds. Fund websites such as Globefund and Morningstar post the top 10 holdings of listed funds. Fund companies should have the complete holdings for their funds posted on their own websites.
Once you have identified a stock of interest, check out the company behind the stock:
- Review the company's website. See what major investing websites and your discount broker have to say about the company.
- Can it be purchased easily? (i.e. does it trade on a Canadian and/or U.S. exchange?)
- Decide if the company has a future. The product or service should make sense to you. Are there recognizable opportunities to grow the business?
- Read up on the company's management. Look for a stable, experienced senior management team.
- Examine the company's profits. Companies worth buying have growing profits.
- What are the company's revenue sources? You want to see real, ongoing revenue, which grows year over year.
- Is there a dividend and is it growing? Does the company offer a dividend reinvestment plan? Paying dividends to shareholders requires profits and business discipline.
- How much debt is on the books? Avoid companies with too much debt compared to their earnings.
If the stock passes your review, make sure it fits into your overall portfolio. Finally, decide on the price you are willing to pay and put in your order to buy.
Here is an example of what a stock portfolio built using the above approach might look like:
Consumer products and services
Shoppers Drug Mart
Industrial products and services
Canadian National Railway
Johnson & Johnson
Bank of Nova Scotia
Great West Life
If you invest in stocks directly, take the time to plan your overall approach and do your homework before you buy. Careful stock purchases will minimize the need to sell. Buy quality stocks for the long run, then sit back and reap the rewards.